1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

As the risk increases the potential return increases as well. In order to get higher returns one needs to invest in riskier assets. In other words, risk is the probability of negative outcome and return is the compensation for this risk.

2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these topics.

The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas greater than 1, show a more intense version of the market behavior. Stocks with betas between 0 and 1 move in the same direction with the market. Since the market is the portfolio of all the stocks, the average stock has a beta of 1.

3. How should Bill demonstrate the meaning and advantages of diversification to Mary?

Comparing expected returns from non-diversified investments with the diversified investments could be a good way of demonstrating the meaning and advantages of diversification. Table 1 shows the expected returns without diversification and Table 2 and Table 3 show the expected returns when different proportions invested in different stocks.

Table 1

Table 2

Table 3

For example when total 100% is invested to High Tech Company, the expected return is 0,05 whereas when only 5% is invested in HighTech and the remaining of the investment is diversified among other stocks, the expected return is 0,05975 and when 15% is invested in High-Tech the expected return is 0,05735. Using the tables above similar comparisons can be made to explain the advantages of diversification.

4. Using a suitable diagram explain how Bill could use the security market linet o show Mary which stocks could be undervalued and which may be overvalued?

Security Market Line is a straight line which gives the relationship between the expected rate of return and the market risk of over all market.

(http://www.saga.vn/Upload/tweety/sml.gif)

The x-axis represents the market risk or beta, and the y-axis represents the expected rate of return. The risk free rates (T-Bills) are represented with a horizontal line.

Security Market Line is a useful tool to determine whether a stock is under- or overvalued. On the plot, if the expected return of a stock is above the SML for a specified beta, then this stock is considered as undervalued and expected to give high return for the risk taken. On the other hand, if the expected return of the stock lies below the SML, this indicates that this stock is overvalued, and it is very likely to offer lower returns.

5. During the presentation, Mary asks Bill “Let’s say I choose a well diversified portfolio, what effect will the interest rates have on my portfolio?” How should Bill respond?

When the portfolio is diversified, the interest rates will have less effect on the portfolio than that they would have on a non-diversified portfolio. Because their positive effect on one part of the portfolio will be neutralized by their negative effect on another part. However the amount that would be neutralized would change in relation the diversification ratios as well as the corelation between them. Correlation...

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1. Imagine you are Bill. How would you explain to Mary the relationship between risk and
return of individual stocks?
As the risk increases the potential return increases as well. In order to get higher returns one
needs to invest in riskier assets. In other words, risk is the probability of negative outcome and
return is the compensation for this risk.
2. Mary has no idea what beta means and how it is related to the required return of the stocks.
Explain how you would help her understand these topics?
The beta measures the sensitivity of a stock’s price to market movements. Stocks with betas
greater than 1, show a more intense version of the market behavior. Stocks with betas between
0 and 1 move in the same direction with the market. Since the market is the portfolio of all the
stocks, the average stock has a beta of 1.
3. How should Bill demonstrate the meaning and advantages of diversification to Mary?
A portfolio is simply a combination of investments. If an investor puts half of his funds into an
engineering company and half into retail shops firm then it is possible that any misfortunes in
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...﻿
1-Imagine your Bill. How would you explain to Mary the relationship between risk and return of individual stocks?
The relationship between risk and return is believed to be positive. In other words, the return is simply considered as a compensation for bearing risk. That basically means the potential return rises as the rate of risk increases. So in order to get a higher return we need to invest in riskier project. So if we were to invest in a high risk securities the return would be higher, in return if the market falls for any economic, financial or political reason, the losses could also be quite large.
And that could be clearly illustrated in the chart below:
2-Mary has no idea what beta means and how it is related to the required rate of return of the stocks. Explain how you would help her understand these concepts.
The beta value for a share indicates the sensitivity of that share to general market movements.
A share with a beta of 1.0 tends to have returns which move broadly in line with the market index. A share with a beta greater than 1.0 tends to exhibit amplified return movements compared to the index. For example, a company has a beta of 1.55 and according to the CAPM when the market, when the market index return rises by say 10 percent the returns on that company shares will tend to rise by 15.5 percent. Conversely if the market falls by 10 percent then the...

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geoff.webster@tafe.qld.edu.au
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Training Package: BSB07 Business Services Version: 9.0
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| | | | | | |Company |
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